Inflation volatility: The war between central banks and COVID-19

Taha Bhatti

The economic bearing of COVID-19 is prevalent through both supply and demand shocks, with a variety of impacts throughout different areas. Whilst most markets have been in a state of excess supply (e.g. discretionary retail), others are in a state of excess demand (e.g. supermarkets). In response, central banks have injected unparalleled money supply into the system, raising concerns for a spike in inflation. The influx of opposing price forces leads to volatility in inflation, an unfamiliar narrative for many in younger generations. 

Whilst this is a complex and widely disputed topic, this article aims to cover major relevant drivers for short, medium, and long-term inflation. 

Firstly, we explore the short-term deflationary impact of COVID-19 on the economic and business environment. Secondly, we investigate the medium to long-term inflationary consequences of modern monetary policy. Finally, we outline several deflationary forces that remain prevalent throughout each time period, such as the liquidity trap, wealth gap and technology.


  1. COVID-19 and Deflation
  2. Central Banks and Inflation
  3. Deflationary Forces over Time
  4. Conclusion

COVID-19 and Deflation

1. Economic cycle 

COVID-19 has caused one of the largest global economic shocks in modern history. Lockdown restrictions and closed borders have effectively limited human movement and halted immigration, resulting in an extreme weakness in demand. Increased optimism from easing of restrictions and the progression of a vaccine infer that we have likely moved past the largest sequential monthly declines in inflation. However, the weakness in demand is expected to linger as repercussions of lockdowns transpire.

High unemployment, low wage growth, and a decrease in net wealth (i.e falling property prices) are expected to  persist after restrictions have eased. This partial economic recovery is likely to result in wider output gaps that exacerbate deflationary movements. OECD forecasts a fall in economic activity of 6.0% in 2020 and an increase in unemployment to 9.2% from 5.4% in 2019.

Historically, inflation has served as a lagging indicator of economic growth, demonstrating significant deflation amid economic recessions. However, the speed and depth of this contraction has accelerated deflationary forces.

Machine generated alternative text:
A collapse in output followed by a slow recovery 
World GDP, index 2019-Q4=100 
In both scenarios, we won't be back at 2019-Q4 level for at least 2 years 
source: OECD (2020), 
November 2019 
Double-hit scenario 
"OECD Economic Outlook No. 107 (Edition 2020/1)", OECD Economic Outlook: Statistics and Projections (database).
Contraction in economic output from both single-hit, and additional double-hit scenarios are forecasted to recover partially in the short-term.
Source: OECD (2020), “OECD Economic Outlook NO.107 (Edition 2020/1)”, OECD Economic Outlook: Statistics and Projections (database).
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Single-hit scenario Additional impact from double-hit scenario 
United States 
United Kingdom 
Euro area 17 
Source: OECD (2020), Unemployment rate forecast (indicator). @ OECD Terms & Conditions
The impact of a single-hit, and additional double-hit scenario of COVID-19 on unemployment.
Source: OECF (2020), Unemployment rate forecast (indicator).
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Consumer Price Index for All Urban Consumers: All Items in U.S. City Average 
— Real Gross Domestic Product 
Sources: BEA, BLS 
Shaded areas indicate U.S. recessions
CPI (blue) tends to lag GDP movement (red). Inflation peaked in the middle of the Global Financial Crisis and bottomed shortly after.
Source: St. Louis Federal Reserve
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Shaded areas indicate U.S. recessions 
When the unemployment rate (red) is above the long-term natural rate (blue), we expect to see deflation (green). The recent divergence is extremely distinct in its depth and speed.
Source: St. Louis Federal Reserve

2. Business cycle 

Cost Structure 

Downwards pressure on prices persists despite the easing of restrictions, as demand issues linger and businesses attempt to attract consumers back into stores using lower prices. Additionally, the availability of cheap credit along with the financial impact of COVID-19 has fuelled unsustainable debt levels in corporations globally, resulting in the prevalence of zombie companies. These are businesses which require additional debt to cover the cost of servicing pre-existing debt. Zombie companies have been offered a lifeline in loose monetary policy, allowing them to restructure debt, sell-off inventory and raise cash to cover running costs.

The collapse of these companies has been delayed, enabling them to continue trading at a loss, and forcing them to reduce prices. Furthermore, key input prices such as oil have seen a dramatic reduction due to various factors, such as a total collapse in global air travel demand. A sustained rally in oil will be required to push inflation back up.

inflation-volatility insolvency out of style
Unparalleled stimulatory measures have delayed the insolvency of many businesses in Australia, who continue trading with lower prices in order to attract customers.
Excess credit

The challenges of deflation intensify during periods of high financial leverage as a reduction in prices, wages, and income increases the real value of debt. As a result, consumers prioritise financial survival, like repaying outstanding debt, which increases the propensity to save. The corresponding decrease in consumption expenditure and consumer confidence results in a stagnant velocity of money. This intensifies the recession and fuels a potential deflationary spiral.

In response to stressed balance sheets and high leverage in a deflationary environment, it is expected that banks tighten their credit standards. The reduction in credit availability further dampens the velocity of money, putting downwards pressure on inflation.

Machine generated alternative text:
Rising Unemployment 
Layoffs & Wage Cuts 
Higher Default Rate 
Bankruptcy more likely given 
lower revenues & profits 
Lower Corporate Profits 
Decreased revenue as prices 
Lower Demand 
Job uncertainty, lower income 
Falling Prices 
Oversupply & lower demand
A deflationary spiral typically consists of these five factors
As tightening standards increase, velocity of money decreases. There has been a significant rise in tightening recently.
Source: St. Louis Federal Reserve

Central banks and Inflation

1. Modern Monetary Policy

Globally, central banks have injected unprecedented money supply in the system aimed at reducing economic carnage, primarily due to the demand freeze from lockdown restrictions. Whilst the rapid decrease in demand and consumption expenditure has diluted much of the increased liquidity in the system, positive shocks such as an easing of restrictions and a vaccine will significantly increase the velocity of money. 

As central banks face a liquidity trap, they become increasingly dependent on measures of fiscal easing, which grows national debt. In order to repay the favour, central banks monetise this debt and relinquish governments from having to rely on tight fiscal policies such as tax raises or reducing spending. This modern relationship sets up a context for retained loose monetary policy in the medium-term. With exorbitant money supply in the system, a significant positive shock in the velocity of money renders inflation as an undeniable risk.

Furthermore, the accumulation of insurmountable levels of debt across governments, businesses and households makes the economy increasingly reliant on inflation as an escape. Inflation destroys the real value of debt, which is fixed in nominal terms, and could stabilise debt ratios if other factors are constant. Of course, these factors usually aren’t constant. 

velocity of money and nominal gdp
There is an unprecedented increase in money supply to counter the dramatic decrease in the velocity of money from lockdown restrictions. Whilst the velocity of money may pick-up, money supply will remain at high levels due to modern monetary policy. With muted real GDP growth in the post-virus recovery phase, the result is likely an increase in price levels.

2. De-globalisation

The impacts of US-China trade wars and COVID-19 can arguably be disruptive to globalisation going forward. International travel and trade remain restricted, countries rush to protect domestic industries, and the emergence of China as a threat to the U.S. creates a dichotomy between two global empires and their allies. If supply chains become increasingly nationalized, or regionally clustered, it may have medium to long-term implications on inflation. Although this is not likely to have a significant impact, it is a risk factor to consider. 

Deflationary forces over time

It is widely known that excess liquidity in the system theoretically results in inflation, as there is more money chasing the same amount of goods. However, we have not seen this manifest over the last few years due to several factors. A few of these factors include:  

1. Liquidity Trap

As central banks buy up bonds, their prices increase, and yields decrease. The risk-free rate – the yield of government bonds – serves as the opportunity cost of holding cash. With a yield approaching 0, investors are not motivated to invest their money at the risk-free rate, as it will not significantly benefit them over holding cash. This is most prevalent for commercial banks – as the money multiplier plunged post crisis, banks became increasingly willing to hold excess reserves.

Therefore, an increase of money supply during a liquidity trap may also result in an increase in cash, such as excess reserves of depository institutions. In other words, part of the money injected into banks, aimed at flowing to the economy (i.e. through loans) is being stored as cash. This exacerbates downwards pressure in the velocity of money, diluting the money supply and minimising inflationary consequences. 

Investors may shift their portfolio holdings from interest-bearing assets to cash or financial assets. When we start to see monetary tightening, yields begin to inflate, encouraging banks and investors to spend more. This was visible during the quantitative tightening that began in 2017, leading to a substantial decrease in excess reserves and an increase in the Federal funds rate. It also resulted in the flattening (and slight increase) of the velocity of money, which was previously spiralling downwards.

While monetary policy remains loose and the Federal funds rate remains low, excess reserves of depository institutions increases. During times of monetary tightening, and Federal fund rate hikes, excess reserves decrease.
Source: St. Louis Federal Reserve
While excess reserves of depository institutions increase (or remain high), velocity of money decreases. When excess reserves begin to decrease, the velocity of money flattens (or slightly increases).
Source: St. Louis Federal Reserve

2. Wealth gap

Another factor with downwards pressure on the velocity of money, and therefore inflation, is a significant wealth gap. In the U.S., as at the first quarter of 2020, the top 50th wealth percentile own 98.5% of the wealth, whilst the bottom 50th own only 1.5%. From 2008 to 2020, wealth ownership declined for all wealth percentiles except for the top 1 percentile. 

From 2008 to 2020, wealth ownership declined for all wealth percentiles except for the top 1 percentile.
Source: St. Louis Federal Reserve

Central banks often inject money supply into the economy by purchasing bonds (i.e. via QE), increasing their prices and suppressing their yields. A large proportion of bondholders tend to be corporations and high net worth individuals, who allocate a significant amount of their capital to fixed income. 

Logically, the more concentrated money is in a system, the more the velocity of money is dependent upon the holders of money. Studies have shown a positive relationship between saving rates and income, demonstrating that the top percentile of wealth holders have a lower propensity to consume. Furthermore, high net worth individuals and corporations tend to invest capital to prevent large deductions in wealth from inflation.

Not only does loose monetary policy inflate the price of bonds, a large portion of the money supply tends to find its way into financial assets, naturally inflating their prices (e.g. equities, real estate). Therefore, we tend to observe asset price inflation, rather than consumer price inflation (e.g. the stock market). As a result of the monetary activities of the largest holders of money, velocity of money fails to increase substantially, diluting money supply and suppressing inflation. 

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High net worth individuals’ breakdown of financial assets. As money supply flows into corporations and high net worth individuals, it makes its way into investment assets such as equities and real estate.
Source: Capgemini Financial Services Analysis, 2018; Capgemini Global HNW Insights Survey 2018.
  1. Technology

The rapid use of technology in producing goods and services efficiently has resulted in a consistent decrease in production costs throughout all industries. The rise of e-commerce has increased competition amongst retailers, who must cut prices to retain and attract customers. Furthermore, the price of electronic computer powered goods and services has seen a dramatic decrease in price overtime. Technological innovation will continue to intensify market competition and increase productivity, causing product prices to decline and dampening inflation over time.

a history of storage cost - matt komorowski
The cost of a hard drive per gigabyte has seen a substantial decrease over time.


The economic repercussions of COVID-19 have created a deflationary period driven by weakness in demand, which decreases consumer confidence and influences business cost structures. The policy response to this exogenous shock has seen unprecedented money supply injected into the system, which is expected to continue due to the dynamics of modern monetary policy. Consequently, we remain in a period of economic weakness along with asset inflation, where excess liquidity redirects into financial markets such as the stock market.

In the medium-term, we expect to see the velocity of money increase, driven by an easing of restrictions and progression towards a vaccine. Since loose monetary policy is expected to remain prevalent, we may see inflationary outcomes grow in the medium to long-term. It should be noted that inflation is expected to remain moderate due to several deflationary dynamics at play, such as the liquidity trap, wealth gap, and technology. 


Bank of England. (2020). Monetary Policy Report – May 2020.

Fraser Institute. (2020). Modern Monetary Theory, Part 3: MMT and Inflation.>

Karen E. Dynan, Jonathan Skinner, and Stephen P. Zeldes, “Do the Rich Save More?,” Journal of Political Economy 112, no. 2 (April 2004): 397-444.

Lv L, Liu Z, Xu Y. (2019). Technological progress, globalization and low-inflation: Evidence from the United States. PLoS ONE 14(4):e0215366.

UNIT. (2020). Market Zombies.

Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a  professional before making investment decisions based off of this article.

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